My comments on Steve Horwitz’s “Mises and His (Apparent) Call for 100% Reserves”

byStephan KinsellaonSeptember 4, 2009

Steve,

Putting aside what Mises thought, it seems to me clear on libertarian principles that as capitalist acts between consenting adults are not aggression and are thus permissible, fractional reserve banking is fine on libertarian grounds so long as there is no fraud. Do you agree with this?

However, given the immense potential for confusion–customers are told they are “depositors” and they often think their money is “in” the bank; while most of it is lent out and thus they get interest–deposit should be distinguished from a loan. The customer should be apprised that he is receiving a credit instrument. Do you agree?

Any claims that he is “guaranteed” to be able to get his money out at any time are also problematic since a run is at least possible. So the “guarantee” language should not be used; this is especially so if the frbnotes contain a suspension clause. Do you agree?

If so, then the only dispute remaining is a purely economic one. You think frbnotes, credit instruments, can circulate as money; some Rothbardians do not (I am not sure). You think it’s possible to have a stable freebanking system that is able to arrange its affairs so as to avoid runs; some Rothbardians do not (I do not). You think the ability of freebanks to expand the supply of money in response to increased demand for money is economically useful, for “stickiness” and similar “market failure” [or so I perceive this argument] reasons; Rothbardians do not (I do not; it seems to me that there is no stickiness problem that needs a solution; and that the freebankers implicitly and fallaciously equate fiduciary money created out of thin air with wealth).

Do you agree that the economic issues in the last paragraph are the basic crux of disagreement between freebankers and 100% reservers? It seems to me that in a free society freebankers would be free to try to set this up; and we would see what happens. (Yes, I know some of you think we have historical evidence already; but the point is the libertarians ought to have no real dispute here; and the economists can either debate on apriori grounds, or on empirical ones–on the latter, one approach is to just try it and see what happens.)

By the way I gather at least some of you freebankers would prefer a 100% reserve gold standard to the current federal reserve fiat money fractional reserve system; and I know I would prefer your private freebanking fractional reserve system to the current centralized statist version of fractional reserve system.

Easy part first: I think your summary of the economic issues in the 4th paragraph is pretty much right on. Not sure I’d say “market failure” but I understand what you’re getting at (it’s only “mf” if one holds perfectly flexible prices as your ideal market, which I would think good Mengerians would not). Those are the crux of it though.

As for the first part: a fractional reserve bank deposit is indeed a loan as well as a deposit. The contract one signs upon getting a checking account should say that (as I believe they generally do). I will note, though, that my own experience with students and friends is that almost everyone understands that not all of their money is literally “in” the bank and that it’s being lent out. Even so, the contract should make this clear.

And yes, the contract should make no stronger claims about the bank’s obligation to redeem on demand being fulfilled than any other contract should about its terms being fulfilled. If you agree to hire me to perform a task, I can’t “guarantee” that I will perform it, I can only promise or agree to. If I break it, then I’m in breach and legal remedies should be applied. Same with demand deposits. If there’s a suspension clause, it’s gotta be there too.

I object to 100% reservers claiming “fraud” for what is really “breach of contract” given that checking account agreements do provide the requisite information.

In short: the notion that fractional reserves are fraudulent has always been absurd to me. Demand deposit contracts should (and do) spell out the terms clearly. If we agree on the “capitalist acts” point, then the dispute is indeed an economic one over the issues you raise.

Right. I am critical of the freebankers’ very view that there is a problem that needs a solution; akin to the false problem of “market failure” that many statists point to. (On this see Salerno’s comments ( http://thinkmarkets.wordpress.com/2009/08/25/auction-markets-and-optimally-sticky-prices/ ) about “sticky” prices, arguing that this notion is an illusion and can’t be invoked as an argument for adjusting the supply of money to variations in its demand.)

“As for the first part: a fractional reserve bank deposit is indeed a loan as well as a deposit.”

? Do you mean the reserve part is a deposit? I suppose so but the problem is that in a straight deposit, the funds of depositors would be pooled as an “irregular deposit” (see Huerta de Soto on this, p. 4 http://www.mises.org/books/desoto.pdf ). But in this case the sum of things depositied is sufficient to cover the entire total of deposits, since it stays in the vault. So as a customer I am indifferent to having, say, ownership of 1 oz coil in a safety deposit box, or 1% ownership of a 100 oz. fungible sum–except that the cost of the former is higher.

But in your case if you say there is a 10% reserve ratio, then 10% of the money handed over is kept in an irregular deposit, but my 1% interst in it is not worth 1 oz. but only 1/10 oz. I mean I am not indifferent, as I would be in the case above. Unless you say the part that is a deposit is only for the 10% of my account value. But the problem with this is if I ask for all of my money you will use the gold to satisfy it. So it’s very confusing to regard it as part deposit. I think it is not part deposit. It’s misleading to say so.

“The contract one signs upon getting a checking account should say that (as I believe they generally do). I will note, though, that my own experience with students and friends is that almost everyone understands that not all of their money is literally “in” the bank and that it’s being lent out. Even so, the contract should make this clear.”

Good. But I do not think most people understand exactly what is going on. They seem to want to have it both ways (no offense, freebankers :)–they want it to be “in” the bank and to get interest too.

“And yes, the contract should make no stronger claims about the bank’s obligation to redeem on demand being fulfilled than any other contract should about its terms being fulfilled. If you agree to hire me to perform a task, I can’t “guarantee” that I will perform it, I can only promise or agree to.”

I agree with this, unless by your choice of words you mean to imply that even a depositary can’t “guarantee” it either. I mean I agree with you, so long as you recognize the categorical distinction between the ability of the depositary-custodian in the case of an irregular deposit, to repay, and the ability to guarantee it in the case of fractional reserves. They are similar only in that in both cases it’s possible for the bank to be unable to meet its promise–but in the case of the irregular deposit this can happen only if there is a violation of the depositary contract (embezzlement), or some kind of random accident (fire) that could be insured against.

“I object to 100% reservers claiming “fraud” for what is really “breach of contract” given that checking account agreements do provide the requisite information.”

Well in my view the 100% reservers have a point given their (in my view justified) view that the origins of fractional reserve are mired in fraud and confusion (I think Huerta de Soto is good on this), and also, based on their economic view of the futility and indeed instability of freebanking, in their suspicion that it’s highly prone to fraud. But I do agree with you that so long as the nature of the arrangement is spelled out, there is no fraud. But I will say that I have sensed many times in the people on your side of this debate a reluctance to agree to the freebanks giving complete and clear disclosure, as if you guys are afraid that too much disclosure will make it impossible for the FRB to get off the ground. I coudl be wrong about this, but I have sensed it and think I could dig up quotes … but anyway, glad you don’t object to this and would be willing to put your system to the test of full disclosure.

“In short: the notion that fractional reserves are fraudulent has always been absurd to me.”

It’s not so absurd if you understand the opponents view of the history of it, the state’s involvement with banking and the origins of frb plus its current involvement with centralized state-run frb; and with their view that freebanking is so inherently unstable and rickety that for it to ever exist there pretty much had to be fraud involved somewhere–I don’t agree with this compeltely, but their reasoning is sufficient to give cause for suspicion and hard scrutiny of the potentially fraudulent nature of this arrangement. But in the end, just as I do not think a ponzi scheme is fraudulent, I do not think FRB (inherently) is.

Further, on the face of it, there is a colorable charge of fraud: you are calling something a “deposit” that is NOT a deposit.

Jake:

“I still don’t understand the economic argument in favor of 100% reserves. How are loans made? Through CDs and mutual funds?”

Basically, through a promissory note. A mutual fund is more like an irregular deposit: you own a pro-rata share of the assets of the fund, which include securities such as stocks and bonds. I don’t think anyone thinks you can’t have loans without fractional reserve banking. The libertarian question is whether handing out frbnotes in exchange for “deposits,” and loaning out 90% of this money, and the customers then circulating these notes “as money” is unlibertarian; it is not, in my view. The economic question is whether this system addresses a real problem, or whether it’s nothing but an unstable shell game.

I’m a little surprised that Stephan Kinsella here uses legal terms loosely or incorrectly, as he is normally very careful with words and concepts.

Anyone can get confused about his legal rights and obligations in making contracts, and it should be, normally, up to the individual whether he wants to take legal advice or even read the contract. Any mistake of law the customer makes in making a deposit to a current account with a bank is going to be a unilateral mistake on the part of the customer: the bank knows what it is doing, even if the customer does not. Legal reasoning is that: ‘Money paid into a bank is money known by the principal to be placed there for the purpose of being under the control of the banker; it is then the banker’s money; he is known to deal with it as his own; he makes what profit he can, which profit he retains to himself. He has contracted, having received that money, to repay to the principal when demanded a sum equivalent to that paid into his hands.’ i.e. people know, or ought to know, that banks are lending institutions, and that current accounts with them fund the bank’s activities. Of course I have nothing against disclosure to the customer, and avoiding or clearing up possible mistakes.

The word ‘guarantee’ or ‘guaranteed’ is properly used when A stands behind the obligation of B, and not when A engages himself alone. This applies to a warehouse as much as to a debtor’s obligations. The warehouse could fail to return your goods, for example due to security breach or fraud. The warehouse’s obligations could, however, be guaranteed by an insurance company that would cover such risks.

Something might be done not so much to solve a ‘problem’ but to exploit an opportunity. For example the airline overbooking practice exploits the opportunity that arises from expected cancelations and no-shows. It would not be a ‘problem’ if there were more empty seats on the average plane, but it would be an opportunity to increase revenue (assuming you have no objection to the law that allows airlines to breach and pay damages when more passengers turn up to fly than the plane’s capacity). The opportunity of fractional reserve banking is to substitute paper for metal, i.e. credit for commodity stocks. Rather than holding larger inventories of metallic money, society holds larger stocks of equipment and buildings etc. You can see this line of reasoning in Adam Smith’s works.

warehouses and debtors both have risks, but the risks are different kinds. In the case of the debtor, the risk is insolvency, as you have no adequate remedy when the means of granting you a remedy are inadequate. In the case of a warehouse, you have two possible remedies: against the goods (if you can find them you can file suit for their return under nemo dat) and against the warehouseman personally, for failure to return the goods (even if he doesn’t have the goods, you can get a remedy from the warehouse’s own assets, if it has any).

You wrote: ‘handing out frbnotes in exchange for “deposits,”’ this shows confusion about both terms. A note is a promissory note, which is a documentary intangible and a negotiable instrument, and this is what a bank note is. A deposit with a bank is not a promissory note, it is a ‘credit’ on the books of the ‘bank’ (or a ‘book credit’) on ‘current account’ made by a ‘customer’ and is repayable by the customer drawing a ‘cheque’ (or ‘check’ for Americans), against his ‘balance’. Thus the term ‘deposit’ should be seen in its context, alongside of the other terms used and the law of banking. They all have complimentary meanings, e.g.
1. a bank is defined as someone who conducts current accounts for his customer, pay customer cheques drawn on him, and collects cheques for the credit of his customer current accounts.
2. a customer is a person for whom the bank has opened a current account.
3. a cheque is a bill of exchange drawn on a bank and payable on demand.
4. the balance is the amount owing by the bank to the customer, the result of the credits for the customer’s deposits of cheques or cash, and interest, and the debits for the customer withdrawals and drawing of cheques on the bank account, and fees.

For example, when a customer deposits a cheque to his current account with the bank, what is the bank supposed to do with the cheque? put it in the vault? return it if the customer asks for it? No, legally the bank holds the cheque as the customer’s agent, and collects it from the drawee bank on behalf of the customer, and applies the proceeds to the customer’s current account. In accounting terms, the bank immediately credits the cheque to the customer’s current account, but, unless the bank wishes to provide credit to the customer, it does not allow him to draw on the proceeds fo the cheque until the cheque is paid, and if the cheque is dishonoured, then the bank will debit it to the customer’s account. In the event that the customer owes money to the bank, the bank has a lien on the cheque in process of collection, and can use the proceeds of the cheque to pay any debt owed to the bank. If you put all the terms used together, there is no confusion left as to what a deposit on current account with a bank means: it is a credit on the books of the bank, and the unsecured liability of the bank. Banks also accept time deposits, and I’ve not heard anyone object to the term ‘deposit’ in this context for what is clearly an interest bearing loan, so why in the case of demand deposits?

“The contract one signs upon getting a checking account should say that (as I believe they generally do). I will note, though, that my own experience with students and friends is that almost everyone understands that not all of their money is literally “in” the bank and that it’s being lent out. Even so, the contract should make this clear.”
– Steve Horwitz

This is the problem with “free”bankers. They claim to use the fact that it “works” and many understand it, TODAY, as an example that this fraudulent practice would survive on the free market.

Almost everyone knows the banks lend out your money TODAY, but they also know that it is guaranteed by the government…so who cares ?

The claim should be that FRB to get off the ground RELIED on fraud, confusion and government privilege, and NOT on open contract and a clear delineation of property rights. George Selgin among others deny this and claim that since SOME people understood, one can simply assume everyone else knew it too…I almost cant take these guys seriously….